Goldman’s Kostin: Stocks are starting to look overvalued

Equity investors take heed: One prominent strategist thinks the S&P 500 index’s valuation is “lofty by almost any measure”.

David Kostin of Goldman Sachs writes that the current price-to-earnings multiple on the S&P 500
/quotes/zigman/3870025/realtimeSPX is about as high as it can get under these current conditions, both as measured by the aggregate index (15.9 times) and the median stock (16.8 times).

After a surge higher in stocks in 2013, Kostin doesn’t see the ratio widening to 17 or 18 times, as “many investors expect”. Rather, a continued rally in stocks will hinge on profit growth.

In a somewhat ironic twist, the sellside is now advising the buyside to temper its optimism, rather than the other way around. Kostin notes that some buysiders have year-end 2014 targets on the S&P that range between 2000 and 2200, which is above his projection, and, we’d add, that of many others on the Street.

Here’s a portion of Kostin’s explanation:

“The multiple expansion cycle provides another lens through which we view equity valuation. There have been nine multiple expansion cycles during the past 30 years. The P/E troughed at a median value of 10.5x and peaked at a median value of 15.0x, an increase of roughly 50%. The current expansion cycle began in September 2011 when the market traded at 10.6x forward EPS and it currently trades at 15.9x, an expansion of 50%. However, during most (7 of the 9) of the cycles the backdrop included falling bond yields and declining inflation. In contrast, bond yields are now increasing and inflation is low but expected to rise.

“Simply put, the earnings yield gap between the S&P 500 and ten-year Treasury yields currently equals about 325 bp. Goldman Sachs Economics forecasts bond yields will creep higher to 3.25% by year-end 2014, a rise of just 25 bp. If the earnings yield gap remains unchanged, then the ‘fair value’ multiple according to the Fed model would be 15.2x at year-end 2014.”

Kostin adds that if inflation is added into the mix, the S&P 500 looks “slightly overvalued”.

Nonetheless, the index does have room to run. Kostin sees a 3% gain to close out the year at 1,900, with the S&P climbing to 2,100 by the end of 2015 and 2,200 by the end of 2016 (The index closed at 1,842 on Friday).

But further multiple expansion? Not as likely. For some historical comparison, Kostin notes that “outside of the Tech Bubble, the market has only rarely (5% of the time) traded at the current forward multiple of 16x.”

Goldman Sachs

It’s a call that other strategists have already taken note of, particularly with earnings season getting underway:

I’m sure we will hear many times tomorrow how Goldman Sach’s analyst Kostin said the S&P is overvalued by every metric.

Of course, the investors that believe multiple expansion could continue to rise have made a case of their own. Ed Yardeni, president and chief investment strategist at Yardeni Research, said last week that volatility could push multiples as high as 19 times.

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